"Payback Period" Important in Capital Budgeting Decisions

LOVELY PROFESSIONAL UNIVERSITY

 LOVELY HONOURS SCHOOL OF BUSINESS 

“   AYBACK  M   ETHOD”  I   MPORTANT  I   N   P   M   I   I   APITAL BUDGETING  D C   D ECISION 

ACKNOWLEDGEMENTS

I would like to express my gratitude to all my loved ones both home and outside, who have have suppor supported ted and encour encourage aged d me throug through h my summe summerr traini training ng report report especially through my rough and tough times. I also owe a special gratitude to GOD for the grace and ability to complete this  project. Finally, I would like to thank my supervisor (Mr. Dilip Kumar, Accounts Mana Manage ger) r),, Lect Lectur urer er Nanc Nancy y Sahn Sahnii for for her her pati patien ence ce,, cons constr truc ucti tive ve advi advice ce and and assistance throughout the duration of my project.

Nivesh Maheshwari August 05, 2009

TABLE OF CONTENTS

Acknowledgement………………………………………………… List of Abbreviations……………………………………………………… Abstract…………………………………………………………… List of Tables………………………………………………

Chapter 1 A1.0 Introduction………………………………………………….

1.1 Research, purpose & justification…………………… justification………………………….. …….. 1.2 Research focus & aims…………………………………….. 1.3 Research methodology……………………………………... A2.0 Review……………………………………………………… 2.1 Capital budgeting…………………………………………… 2.2 capital budgeting process……………………………… process…………………………………… …… 2.2i Strategic planning………………………………………….. ii Identification of o f investment opportunities…………………. opportunities…………………. iii Preliminary screening of project…………………………… project…………………………… iv Financial appraisal…………………………………………. v Qualitative factors in project evaluation……………………. vi Accept/reject decision……………………………………… vii Implementation of monitoring……………………………… viii Post implementation audit………………………………….. 2.3 Importance of capital budgeting to org……………………… 2.4 Theories of method of capital budgeting……………………. budgeting……………………. 2.5 Capital budgeting techniques…………………………… techniques………………………………… …… 2.5i The payback period…………………………………………. i(a Payback period in relation to the t he goals of the comp……….. (b Discounted payback period method………………………… method…………………………

(c Advantages of payback period………………………………… (d Disadvantages of payback period………………………… period……………………………… …… 2.5ii Net present value……………………………………………… (b Disadvantages of NPV………………………………………… 2.5iii Internal rate of return…………………………………………… (a Advantages of IRR……………………………………………… (b Disadvantages of IRR……………………………………………

Chapter 2

-

Overview………………………………………………………. Profile………………………………………………………….. Growth, landmarks & milestones…………………………… milestones……………………………… … Product & service……………………………………………… Operations………………………………………………………

Chapter 3 3.0 Reasons companies use the payback period………………………. period………………………. 3.1 Simplicity of the payback period…………………………………… 3.2 The PB period in relation to pecking-order theory………………… theory………………… 3.3 The PB period as method for risk assessment in capital budgeting… 3.4 The PB period in relation to the size of company…………………… company…………………… 3.5 Management compensation & the role of PB period……………….. period………………..

Chapter 4

-

Analysis of data Limitation of the data analysis

Chapter 5 Conclusion

List Of Abbreviations

ARR

Accounting Rate of Return

CF

Cash Flow

DCF

Discounted Cash Flow

DPB

Discounted Payback Period

ERR

Economic Rate of Return

IRR

Internal Rate of Return

 

NPV

Net Present Value

PB

Payback Method

PP

Payback Period

WACC

Weighted Average Cost of Capital

List of Tables & Charts

Table 2.1 Price comparison of treatment among Indian & other countries Table 4.1 Report of survey conducted conduc ted on companies in U.K. Table 4.2 Extract from the data on the use of capital budgeting bud geting method in Sweden Table 4.3 Data extracted from the survey conducted by John R. Harvey Harve y Table 4.4 Report of question asked from the competitors Flow chart of the Capital Budgeting Process

 ABSTRACT 

TITLE- “Payback Method” Important In Capital Budgeting Decision

Background Background & problem decision : The capital budgeting decision has been a very typical issue issue in the sustenance sustenance of a company. company. Several companies companies have lost their identity or liquidated liquidated due to wrong capital capital budgeting decision decision they made at a particular particular point of time. Based on these common problems in industries and the effect of globalization on industries, it is important to use effective method before making any investment decision. Capita Capitall budgeti budgeting ng is extrem extremely ely import important ant becaus becausee the decisi decision on made made direct directly ly affec affects ts the organization future growth. One of the traditional methods commonly used for capital investment appraisals by some Organizations is the Payback Method, although this method is criticized by academicians as it does not include the time value or future value of cash flow & do not measure  profitability. The wide acceptance of this method has called for a discussion that why this method is still popularly used in the organizations. Here we will examine the reasons major  decision makers in organizations o rganizations still use this method despite it’s critics objections.

PURPOSE : The aim of the research is to investigate the importance of the use of the Payback  method in Capital Capital budgeting decisions in relation to other appraisal appraisal techniques used for capital capital  budgeting decision in organizations.

METHOD : The method used are the theories on the Payback period as it affects decision making in the organization and past research work methods which companies used in appraising investment, are used as Secondary Data in order to have a basic insight into the importance of the

Payback Payback method in Capital budgeting. budgeting. The theories theories help us to look, the methods that are often used used in the capita capitall bud budget geting ing decisi decision on showin showing g the advanta advantages ges and disadva disadvanta ntages ges that that are associated with each method.

Here we intend to try to find out ou t the following things: •

Why do compan companie iess pref prefer er to use use paybac payback k meth method od when when they they evalu evaluat atee inve invest stme ment nt opportunities?

•

Is the payback method a simple approach?

•

Does this method have anything an ything to do with financial flexibility?

•

How does the payback method affect the evaluation of managers?

•

Is the use of payback period related to the size of the company? co mpany?

ANALYSIS: The analysis is done on the basis of various research works that have been done on the payback period, and different data of the survey of the research is being used as secondary data to obtain the result. From the analysis, the trend showed that the Payback method has been commonly used in appraising capital budgeting decisions d ecisions in various organizations.

CONCLUSION: It is clear from the research that the payback method is often majorly used in the organizations allover the world despite its criticism by academicians, making inference from the analysis of companies. The importance of the payback method, which includes but not limited to its simplicity, liquidity and risk assessment have made the method to be gaining more awareness in appraising investment opportunity by practicing manager.

KEY WORDS: Capital Budgeting, Payback Method, Payback Period, Net Present Value, Internal Rate of Return.

Chapter 1

(A) 1.INTRODUCTION

The first chapter aims to introduce the reader to the research topic, background problem, purpose and to the limitations that will be discussed.

1.0 INTRODUCTION The payback method is commonly used for capital budgeting investments in companies despite its theoretical deficiencies. The payback method is often used when aspects like Project time-risk  and Liquidity are focused and pure profit is single criterion. In practice, the maximum acceptable  payback period is chosen as fixed, for example, let say 6 years. In some cases, the limit value of  the payback period is chosen in relation to the economic life of the project or investment, for ex:  payback period could be shorter than the economic life of the project. Mostly the payback  method is used as a foremost device to sort out the obvious cases of profitable or unprofitable investments, leaving the other means which are more advanced and time consuming methods   based on Discounted cash flows, such as the Internal rate of return(IRR) and net present value(NPV) methods (Statman and Sepe 1984 ). However there are various companies of considerable size, where the payback period is used as a single single criterion criterion in investment investment evaluations. evaluations. The use of Payback Payback period period method method as the primary primary or  only method is often used in small & medium size companies. However it should be noted that  payback method can be developed to handle cases with varying cash flows, though some of its simplicity is lost in process. This is a fact that the decision situation in the evaluation o f capital

 budgeting investment is typically uncertain considering the time pattern and the duration of cash flows, flows, the use of the simple simple and more robust payback payback method can be justified justified even if there will  be time for more advanced analyses methods. Before, we move into more details of Payback method, lets have a clear understanding of capital  budgeting and its techniques:

1.1 RESEARCH, PURPOSE PURPOSE & JUSTIFICA JUSTIFICATION TION

The capital budgeting budgeting decision decision has been a very typical typical issue in the sustenance sustenance of a company. company. Several companies have lost their identity or liquidated due to wrong capital budgeting decision they made at a particular point of time. Due to these problems in industries and the effect of  globalization, it is important to use effective method to analyze investment decision before it is made. Capital budgeting is extremely important because the decision made directly affects the organization future growth.

One of the tradit tradition ional al methods methods commonly commonly used used for capital capital invest investmen mentt apprais appraisals als by some some Organizations is the Payback Method, although this method is criticized by academicians as it does not include the time value or future value of cash flow & do not measure profitability. The wide acceptance of this method has called for a discussion that why this method is still popularly used used in the the organ organiz izat atio ions ns.. Here Here we will will exami examine ne the the reas reason onss majo majorr deci decisi sion on maker makerss in organizations still use this method despite its critics objections. Could the reason be traced to the simplicity of this method in capital budgeting than other  investment appraisal method or could it it be other reasons? Although modification of the Payback  method to consider the future cash flow which is discounted payback period (DPB) has been be en able to reduce to some extent the deficiency of Payback Period, on which the company emphasize. The objective of the research is to consider the reason for the use of the payback method in making capital budget decision in organizations. Here we will consider in brief all investment appraisal technique used for capital budgeting budge ting decision in organizations with major emphasize

on payback method . We will investigate the importance of use of payback method in capital

 budgeting. We will also examine the importance of payback method in relation to simplicity, manager incentive compensation and the size of the company.

1.2 RESEARCH RESEARCH Focus Focus & Aims

The research is focusing on the capital budgeting decision making in the organization. The traditional investment analysis method will be discussed which will include but not limited to  payback period, IRR, NPV. Key essence of the payback method will be discussed in detailed and why it is employed by practicing managers for investment appraisals, despite of its critics. The main focus of the research is: •

Why do compan companie iess pref prefer er to use use paybac payback k meth method od when when they they evalu evaluat atee inve invest stme ment nt opportunities?

•

Is the payback method a simple approach?

•

Does this method have anything an ything to do with financial flexibility?

•

How does the payback method affect the evaluation of managers?

•

Is the use of payback period related to the size of the company? co mpany?

1.3 RESEARCH RESEARCH METHODOLOGY METHODOLOGY

The method to be used in the research is the theories on payback period as it affects decision making in organization. The past research work on methods which company used in appraising investment will be considered, and this will serve as secondary data to make inference in order to  be able to answer the questions raised in the focus and have a basic insight into the importance of  Payback method in capital budgeting decisions. The data will be the secondary that relate to the size of the company, the data shows how the  payback method is being used in different companies and countries. The use of the secondary data will involve the extraction of relevant information from the data provided in the various articles considered, which will also show how different data extracted from the various articles can be analyzed to get our answers. Also the data of the articles/journals will be analyzed and

conclusion will be made why the companies use the method based on empirical studies and   per perso sonal nal judg judgme ment nt.. Furt Further her,, the the analy analysi siss of the the data data will will also also show show how how the the compan companie iess (practicing managers) have favored the use of the payback method.

(A)2. LITERA LITE RATURE TURE REVIEW RE VIEW 2.0 Review The literature review provides background explanations of the elements of the research work  such as Capital budgeting, capital budgeting process, theories of method of capital budgeting, techniques techniques of capital budgeting budgeting with emphasis on the payback method and the payback method in relation to the goal function of the company. This is also an overview of  literature and past research work in related areas which provide a platform for the research.

2.1 Capital Budgeting Capital budgeting is a process in which a business determines whether projects such as building a new plant or investing in a long term venture are worth or not. Most of times, a prospective  project’s lifetime cash inflow and outflows are assessed in order to determine whether the return generated meet a sufficient target. Capital budgeting is also known as Investment Appraisal. Ideally, business should do all those projects and opportunities which enhance shareholders value. Generally, businesses prefer to study a project before taking it on, as it has a great impact on the company’s financial performance. Capital budgeting is an important tool. One important duty of a financial manager is to choose investments with satisfactory cash inflows and rate of  return. A financial manager should be able to decide if an investment is worth undertaking and should also have the ability to choose cho ose intelligently given other alternatives. Capital budgeting is

 primarily concerned with sizable investments in long term assets. These assets can either be tangible items such as property, plant & machinery or intangible ones such as new technology,   patents or trademarks. trademarks. Investments in in processes such as research, design design and development and testing- through which new products are created may also be viewed as investments in tangible assets. (Don Dayananda et al 2002)

Sizable, long term investments in tangible and intangible have long term consequences. An investment today will determine the firm’s strategic position in coming years. These investments also have a considerable impact on the future cash flows and risk associated with those cash flows. Thus capital budgeting has a crucial impact on the firm’s performance and on the firm’s success & failure. So capital budgeting decisions have a major effect on the value of the firm and its shareholder wealth as whole. (Don Dayananda et al 2002)

Financial management largely concerns with financing, dividend and investment decisions of the firm. Corporate Corporate finance theory has developed around a goal of maximizing maximizing the market value of  the firm to it shareholders, which is also known as shareholder wealth maximization. Financial decision deal with the firm’s optimal capital structure in terms of debt & equity. Investment decisions deal with the funds raised in financial market are employed in productive activities to achieve the firm’s overall goal, or we should say, how much should be invested and what assets should be invested in. (Don Dayananda et al 2002)

In reality, many firms have limited borrowing resources that should be allocated among the best investment alternatives. Many people would argue that a company can issue an almost unlimited amount of capital stock to raise capital. Increasing the number of shares of company stock will serve only to distribute the same amount of equity among a greater number of shareholders. In other words, as the number of shares of a company increases, the company ownership of  individual stockholder may proportionally decreases. The argument that capital is a limited

resource is true of any form of capital, whether debt or equity or retained earnings, accounts   payable or notes payable and so on. Even the best-known firm in an industry increase its  borrowings up to a certain limit. Once this point has reached, the firm will either be denied more credit or be charged a higher interest rate. Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of  more than one project, management must identify the projects that will contribute most to profits and to the value of the firm. This is the basis of Capital Budgeting.

2.2 Capital Budgeting Process There are different sequential stages in the capital budgeting process. The capital budgeting  process is a multi-faceted activity. The sequential stages of a capital budgeting process can be depicted in a simple flow chart below – 

Corporate Goal ↓ Strategic Planning ↓ Investment Opportunities ↓ Preliminary Screening ↓ Financial appraisal, Quantitative Analysis, Project evaluation or project analysis ↓ Qualitative factors, judgments and gut feelings ↓

↓

Accept

Reject

↓ Implementation ↓ Facilitation, monitoring, control & review ↓ Continue, expand or abandon project ↓ Post implementation project

Figure: Flow Chart of the Capital Budgeting Process

2.2(i) Strategic Planning It could be referred as the actual design of the organization which specifies the type of the  business of the organization and where it intends to position itself in the future. It translates the organization’s corporate goal into specific policies and directions, set priorities, specifies the structural, strategic and tactical areas of business development and guides the planning process. organizat zation ion’’s vision vision & missi mission on is also also embedd embedded ed in its strat strategi egicc (Drur (Drury y et al. al. 1993) 1993) An organi  planning. The feedback to strategic planning during project evaluation and decision stages is very critical as it affects the future direction or the organization.

2.2(ii) Identification of Investment Opportunities Identi Identific ficati ation on of invest investmen mentt opportu opportunit nities ies and genera generatio tion n of viable viable projec projects ts propos proposal al are important steps in capital budgeting. But project proposals have to fit according to goals and vision of the company, sometimes company faces two paths when there is an opportunity of a good project and company have to mould there goals and vision accordingly. Some investments are mandat mandatory ory while while others others are discre discretio tionar nary y and are generat generated ed by growth growth opportu opportunit nities ies,, competition, cost reduction and so on. Thee organ Th organiz izat atio ion n shou should ld endea endeavor vor to sear search ch and and iden identi tify fy potent potentia iall lucr lucrat ativ ivee inve invest stme ment nt opportunities and proposals because the remaining part of the capital budgeting process can only assu assure re that that the the best best of the the prop propos osed ed inves investm tmen entt prop propos osal alss are are eval evalua uate ted, d, sele select cted ed and and implemented.

2.2(iii) Preliminary Screening of Projects Mostly, many investment proposals generated within the organization and obviously they don’t all scale scale throug through h the rigoro rigorous us project project analys analysis is proces process. s. Therefo Therefore re the propos proposed ed invest investmen mentt opport opp ortuni unitie tiess are subjec subjected ted to furthe furtherr prelim prelimina inary ry screeni screening ng by managem management ent to isolat isolatee the unreasonable proposal so that the resources will not be wasted in evaluation of such projects. At

times, the preliminary screening may involve quantitative analysis and judgments based on intuition and experience.

2.2(iv) Financial Appraisal Proposals which are through to the preliminary screening phase are subjected further to rigorous financial appraisal to ascertain if they add value to the organization. This stage is also called quantitative analysis, economic and financial appraisal, project evaluation or simply project analysis. It predicts the expected future cash flows of the project, analyze the risks associated with those cash flows, develop alternative cash flow forecast, examine the sensivity of the results, subject the cash flow to simulation and prepare alternative estimate of the project’s net concepts, principles and techniques techniques of project project present value (Brian Baldwin 1997). The basic concepts, evaluation evaluation are same for different different projects projects while their application application to particular particular types of projects projects needs needs spec specia iall know knowle ledge dge and and exper experti tise se.. For For examp example le:: asse assett expa expans nsio ion n proj project ects, s, asse assett replacement, & international investment and so on… It should be noted that if the projects identified within the current strategic framework of the organi organizat zation ion repeat repeatedly edly produce produce negativ negativee NPVs NPVs in the analy analysis sis stage, stage, these these result resultss send send a warning signal to the management to review its strategic plan. Therefore the feedback from  project analysis to strategic planning is important in the overall capital bu dgeting process.

2.2(v) Qualitative Factors in Project Evaluation These factors have a impact on the project but are virtually impossible or I should say difficult to evaluate in monetary terms, and these are: •

The societal impact of an increase or decrease in employee numbers

•

The environmental impact of the project

•

Possible positive or negative government attitude towards the project

•

Strategic consequences of consumption of scarce raw material

•

Positive or negative relationship with labor unions about the project

•

Possible legal difficulties with respect to use of patents, copyrights and trademark or   brand names.

From the above factors, some may affect the value of the organization while others may not.  Necessary issues could be addressed by the organization during project analysis by means of 

discussion and consultation. At times, management may be able to predict the impact of some of  the issues through the estimation of monetary cost or benefits of the project and incorporating those values in cash flows.

2.2(vi) Accept/Reject Accept/Reject Decision The results of the NPV from the quantitative analysis combined with the qualitative factors from the basis basis of the decisi decision on inform informati ation. on. The inform informati ation on is passed passed to the management management with appropriate recommendation by the analyst. The management then go through to the given information and also bring in other prior knowledge gained through their routine information sources, experience, expertise and judgment to make a major decision either accept or reject the  proposed investment proposal .

2.2(vii) Implementation & Monitoring Once the management has made decision to accept the investment project, then the project must  be implemented by the management. During the implementation stage, various divisions of the organization are involved. In this phase the constant monitoring of project progress with a view of identifying potential bottlenecks and providing early solutions or alternatives to rescue the situation.

2.2(viii) Post –implementation audit This does not relate to the current decision support process of the project but rather it deals with a post-m post-mort ortem em of the perfor performan mance ce of already already implement implemented ed projec projects. ts. An evaluat evaluation ion of past past decisions can contribute greatly to the current investment decision making by analyzing the past ‘rights’ or ‘wrongs’. The post-implementation audit therefore provides useful feedback to project appraisal or strategy formulation.

2.3 Importance of Capital Budgeting to organization •

Effective capital budgeting helps to improve the timing of asset acquisition and the quality of assets purchased

•

When asset acquisition is planned properly, the organization is able to acquire and install in a manner 

•

Generally all organizations tend to order capital goods at the same time when sales in a  particular industry are increasing strongly. strongly.

2.4 Theories of Methods of Capital Budgeting Capital budgeting decisions are crucial to an organization’s organization’s success for several reasons: •

Capital expenditures typically require large outlays of funds

•

Organizations must ascertain the best way to raise and repay these funds

•

Most capital budgeting decisions require a long-term commitment

•

Finally, Finally, the timing of capital budgeting decision is important.

When large amount of funds are raised, organizations must pay close attention to the financial markets because the cost of capital is directly related to the current rate of interest. The need for  relevant information and analysis of capital budgeting alternatives has inspired in making the “best” allocation of resources. The earliest models were the payback method, which in simple simple terms determine the length of time required to recover its cash outlay, & the return on investment model, which evaluates the project based on standard historical cost accounting estimates. The next concept is the time value of money to obtain a superior measure of the cost/benefit trade-off of potential projects.

Capital budgeting decisions are extremely important and complex and have inspired many research studies in the past. For example: in an in-depth study of the capital budgeting bud geting projects of  12 large manufacturing firms (Ross 1972), that although techniques that incorporated discounted cash flow were used to some extent, ex tent, firms relied so much on the simplistic payback model .

Also, when discounted cash flow techniques were used, they were often simplified. Ex: some firms’ simplifying assumptions include the use of the same economic life for all projects even though the actual life of individual projects might be different. (Ross 1986)

In 1965, J. William Petty, David P. Scott, and Monroe M. Bird examined responses from 109 controllers of 1971 fortune 500 firms concerning the techniques their companies use to evaluate new and existing product lines. They found that internal rate of return was the method preferred for evaluating all the projects. (Petty 1975) Laurence G. Gitman and John R. Forrester Jr. analyzed the responses from 110 firms who replied to their 1977 survey of the 6oo companies companies that Forbes reported reported as having a greatest greatest stock price growth over the 1971-1979 period. The survey containing questions related to capital budgeting techniques, the division of responsibility, the cut-off rate and the methods used to assess risk. They found that the discounte discounted d cash cash flow flow techni techniques ques were the most popular popular methods methods for  evaluating projects. However many firms still used the payback method as a backup. (Gitman 1977)

In 1981, Suk H. Kim and Edward J. Farragher surveyed the 1979 Fortune 100 Chief financial officers about their usage of techniques for evaluating capital budgeting projects. They found majority of firms relied on a discounted cash flow method, as the primary and the payback as the secondary method. (Suk 1981)

2.5 Capital Budgeting Techniques The requirement for relevant information and analysis of capital budgeting decisions has lined a series of models to assist the organization in to use their resources best. Popular methods are:

•

•

•

The Payback Period  Net Present Value (NPV) Internal Rate of Return (IRR)

2.5(i) The Payback Period It is defined as the time required to recover the initial investment in a project from operations. This method is used to evaluate capital projects and to calculate the return per year from the start of the project until the accumulated returns are equal to the cost of the investment at which time the investment is said to have paid back and the time taken to achieve this payback is referred to as the payback period . Payback is said to emphasize the management’s concern with liquidity and the need to minimize risk through a rapid recovery of the initial investment. (Cooper, William D. Morgan et al. 2001)

It should be noted that the required payback period sets the barrier for the project acceptance. It often appears that in many cases the determination of the required payback period is based on subjective assessment, taking into past account experiences and the level of project risk. The  payback period has shown to be an important, popular, primary and traditional method in the developed nations like the UK and USA (Pike 1985)

Typically, the payback period expected by the managers appears to be in the range of 2 to 4 years. This method by definition, only takes into account project returns upto the payback period. However, for certain projects which are long term by nature and whose benefits will accrue in the future and beyond the normal payback may not be accepted based on the calculation used by the payback method, although such projects may actually be vital for the long term success of the  business. It is important to use the payback method more as a measure of project liquidity rather  than project p roject profitability. profitability.

The payback method is commonly used for appraisal of capital investments in companies despite of its deficiencies and in some it is used as a measure of attractiveness of capital investments. Although the use of this method as a single criterion has decreased over time, it is used as a secondary measure increased over time. (Segelod 1995) This method is commonly used in pure

 profit evaluations as a single criterion and also sometimes used when focusing on aspects such as liquidity and project time risk. The obvious case of profitable & unprofitable investments are sorted out, when the payback method is used as the first screening device, leaving only the investments that have survived the screening process in the middle group to be scrutinized by means of advanced and more time consuming calculation methods based on discounted cash flows (DCF), such as the internal rate of return (IRR) and net present value (NPV) methods. However, there are many companies where the payback period is used as a single criterion in investment evaluations. (Blatt 1979) Most importantly the overall conclusion seems to reveal that the payback method is much in use by companies for investment appraisals and it is therefore necessary to reduce some of its deficiencies.

The major deficiencies of the payback method are that it ignores cash flows after the payback    period and it does not measure the time value of money in correct manner. To reduce these deficiencies the maximum acceptable payback period should be chosen as a fixed value, say 3 yrs and in some cases the limit value of the payback period has been related to the economic life of the investment, for ex: a payback pa yback period that is shorter than half the economic life. When these two rules of thumb are combined, a more theoretically correct evaluation of investments can be achieved achieved and such a combined combined payback method is based on assumption assumption of constant constant yearly cash flows. The payback time limit has been criticized by theorists because it ignores profits which may accrue in the subsequent life of the project. The criticism is unjust, the practical men are complet completely ely right. right. In a riskle riskless ss world world future future profit profitss are certai certain. n. But in the real world, world, the imposition of payback time limit is a necessary protection for the survival of the planning manager. Infact payback time limit is used by every responsible manager.

2.5(i) a. Payback Method in Relation to the Goals of the Company In the the paybac payback k meth method od comp compan anie iess will will go ahea ahead d with with an inve invest stme ment nt if the the retu return rn of the the investment is higher or larger than the capital cost. Generally, most companies go ahead with an investment decision if the following conditions hold true.

1) NPV > 0 This means that for a good investment decision to be made, the net present value must be greater than zero.

2) IRR >W >WACC (i.e. (i.e. cost cost of of capital capital)) This says that the internal rate of return is expected to be greater than weighted average cost of capital for executing the capital budget under consideration.

3) NPV+ NPV+ Option Option value value (Str (Strate ategic gic NPV) NPV) >0 >0 This explains the net present value in addition addition to the option value must be greater greater than zero to make a good investment decision. The above conditions are used because they increase the principal’s wealth (i.e. shareholder’s wealth) and ultimately add value to the company as a whole. The goal function of the company is one of the major criteria in the investment decision of the company. Investment that will add value to the company is always chosen, and majorly the investment that maximizes the present future value of cash flow. To find out, if the goal function of the company is supported by the payback method, we have assume the goal function of the company in the Research. In the research, the goal function of  the company is focusing on maximizing the long run market value of the firm by maximizing the net benefits from activities such as investments with positive returns. (Numminen 2008) The goal function of the company is said to maximize the present value of future cash flow which is easily supported by the net present value method and the internal rate of return method. It is noted that the payback method is majorly used for appraising capital projects which have short

term such as 3 years. The development of the relationship between the internal rate of return and the payback method has shown that the payback method do measure profitability of investment. The literature has shown that the payback pa yback period is an approximation of internal rate of returns of  infinite life and uniform cash flow. (Frank Lefely 1996) According to studies, the payback 

method has been employed because some practicing manager believe that it is the approximation of internal rate of return and that it also support the goal function of the company. This is also one of the reasons the payback method is still relevant in industries.

2.5 (i) b Discounted Payback Period Method The payback method have gone through various development stages over the years, eliminating some of its disadvantages and at the same time keeping it as simple as possible. The payback  method based on discounted cash flow figures was proposed by, Rappaport 1965 . This method attempted to overcome one of the drawbacks of the conventional payback calculation which failed to take into account company’ c ompany’ss cost of capital. Longmore 1989 , proposed a generalized time-adjusted payback rule which states that “If the

investment proposal’s payback, adjusted for the timing of the net cash flows, is less than or equal to the present value of annuity factor at the firm’s cost of capital for the life of the proposal, the investment should be accepted.” He argues that by adjusting the discount rate, the discounted  payback decision rule can be modified to handle risky investments. In practice it appears that the standar standard d payback payback DCF uses uses discoun discounted ted figure figuress in its calculati calculation on but allows allows manager managerss to determine the payback hurdle rate, which in many cases is based on the subjective judgment. It should however be noted that the payback period is determined from the present value annuity factors used and not predetermined by b y the managers. It is computed as follows: Initial Investment

Payback Period = Annual Operating Cash Flows

OR 

Cost of Project

Payback Period = Annual Cash Flow

In payback method, the projects with shorter payback periods rank higher than those with longer   paybacks.  paybacks. The reason is that projects projects with shorter period are more liquid and thereby thereby less risky i.e. they allow the organizations to recoup the investment sooner, so that the money can be invested elsewhere. Also in shorter period there is little or no chance that market conditions, intere interest st rates, rates, the economy economy,, or other other factor factorss affec affectin ting g the propos proposed ed projec projectt will will drast drastical ically ly change.

2.5(i) c Advantages Advantages of Payback Period •

It is widely used and easily understood

•

It favors capital projects that return large early cash flows

•

It allows a financial manager to cope up with risk by examining how long will it take to recoup initial investment

•

It addresses capital rationing issues easily

•

The ease of use and interpretation permit decentralization of capital budgeting decision which enhances the chance of only worthwhile items reaching the final budget

•

It contains a built-in safeguard against risk and uncertainty in that the earlier the payback  the lower the risk 

•

It remains a major supplementary tool in investment analysis

2.5(i) d Disadvantages Of Payback Period •

It ignores any benefits that occur after the payback period i.e. it does not measure total income

•

The time value of money is ignored

•

It is difficult to distinguish between projects of different size when initial amounts are vastly divergent

•

It over-emphasizes short run profitability

2.5 (ii) Net Present Value The Net present value is defined as the different between the present value of the cost of inflows and the present value of cash outflows. In other words, a project’s net present value is computed as the present value of cash flows from operations and disinvestments less the amount of the initial investment. In computation of NPV, the cash flows that occur at different point of time are adjusted for the time value of money using a discount rate that is the minimum rate of return required for the project to be acceptable. Project with +ve NPV are acceptable and –ve are unacceptable. NPV is used in capital budgeting to analyze the profitability of an investment and it is sensitive to the reliability of future cash flows that the investment will yield. For example: the NPV compares the value of rupee today of that same rupee in the future taking inflation and returns into account. The NPV is computed as follows:

N.P.V N.P.V.. = Present Value Value of Cash Inflows Inflow s – Initial Init ial Investment Investm ent

 Note that higher NPVs are more desirable. The specific decision rule for NPV is as follow:  NPV < 0, reject project NPV >0, accept project

2.5 (ii) a. Advantages of NPV •

It is considered to be conceptually concep tually superior to other methods

•

It does not ignore any period in the project life or any cash flows

•

It is mindful of the time value of mone y

•

It is easy to apply NPV than IRR 

•

It prefers early cash flows compare to other models

2.5 (ii) b. Disadvantages of NPV •

The NPV calculations unlike IRR method, expects the management to know the true cost of capital

•

 NPV gives unclear comparisons between projects of unequal size or unequal economic life. In other to overcome this limitation, NPV is used with Profitability index.

2.5 (iii) Internal Rate of Return (IRR) The internal rate of return is the discount rate often used in capital budgeting that make the net  present value of all cash flows equal to zero. This means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of project equal current market value. (Stefan Yard 1999) The higher the project’s internal rate of return, the more desirable it is to undertake. It is used to rank several prospective projects a firm is considering. The IRR provides a simple hurdle, whereby any project should be avoided if the cost of capital exceeds this rate. IRR is also referred as economic rate of return (ERR). So a simple criteria can  be, accept a project if it’s IRR exceeds the cost of capital and reject if IRR is less than cost of  capital. Although the use of IRR could result in a number of complexities such as a project with multiple IRRs or no IRR. Internal rate of return is the flip side of NPV, NPV, where NPV is discounted value of a stream of cash flows, generated from investment.

2.5 (iii) a. Advantages of IRR  •

It is straight forward and easy to understand

•

It recognizes the time value of money

•

It is uses cash flows

2.5 (iii) b. Disadvantages of IRR  •

It often gives unrealistic rates of return and unless the calculated IRR gives a reasonable rate of reinvestment of future cash flows, it should not be used as a base to accept or  reject a project

•

It may give different rates of return

•

It could be quite misleading if there is no large initial cash flow

Chapter 2

 B L LIFESCIENCES PVT LTD

Overview Medical Medical industry industry is actually actually thousand of years years old. India is a recent entrant entrant in this industry. industry. As   per research reports, approx.1,50,000 medical tourists came to India in 2002, according to hospitals offering McKinsey and the Confederation Confederation of Indian Industry. Industry. India has number of hospitals world class treatments in nearly every medical sector – Cardiology & cardiothoracic, joint replacement, orthopedic surgery, transplants and neurology and many more…. India has a large  pool of doctors (approx. 6,00,000). In India, complicated surgical procedures are being done at 1/10 th the cost as compare to developed countries like U.K, Canada & Europe. Price Comparison Comparison of India, U.S. & U.K 

TREATMENT

Open Heart Surgery Neurosurgery Hypothermia Complex Spine surgery with

APPROX. Cost In Cost

In

INDIA ($)

Healthca Healthcare re

with

4 ,5 0 0 6 ,50 0

Major Major

Other

Destination ($) >18,000 >21,000

4 ,30 0

>13,000

implants Simple spine surgery Simple Brain tumor 

2 ,1 0 0

6,500

-Biopsy

1,000

>4,300

-Surgery

4,300

>10,000

This is the main reason of the origin o rigin of  B  B L Lifesciences Pvt Ltd. B L Lifesciences Pvt Ltd is a part of BL Group companies which has been in the business for  over 50 yrs (since 1984) . BL is the initials of respected grandfather Mr Babu Lal Aggarwal. It is a family owned business & it includes one of the largest & oldest pharmacy in Delhi, Exports of  Apparel, besides manufacturing and marketing of several Bio Medical Devices in India & the Asia Pacific Region.

 PROFILE  Since 1985, BL has been marketing a wide range of Cardiovascular equipment and critical care devices in India. Over the past 20 years, company has amassed a vast amount of experience. It’s that experience combined with leading edge technology which has allowed company to develop such high quality products. The objective of this effort has been, not only superior products but competitive prices. BL established it’s manufacturing facility in 1999 with a vision to be an innovative and competitive world class Medical Device Manufacturer emphasing on Quality, customization and contract manufacturing.

Growth, Growth, Landmarks & Milestones

1984 1986 1998 199 8 1999 199 9 2000 200 0 2001 200 1 2003 2004 200 4 2005 2005 2005 2006 200 6 2008 200 8

BL Mark Marketi eting ng Servic Services, es, Found Founded ed by Mr. Mr. Ajay Ajay Aggarw Aggarwal al Mr. Mr. S Suni unill Aggarw Aggarwal al join joined ed as as Dire Directo ctor  r  Facto Factory ry cons constr truct uctio ion n work work star starte ted d US$4 US$4 mill millio ions ns targ target et achi achiev eved ed Facto Factory ry opera operati tion onss star started ted Singa Singapo pore re oper operat atio ions ns star starte ted d Factory accredited accredited by ISO9001 ISO9001 certific certificate ate and and CE CE marked marked to product productss US$6 US$6 mill millio ions ns targ target et achi achiev eved ed Busines Businesss trans transfer ferred red to to new name name 'BL 'BL Lifes Lifescie ciences nces'' ISO1 ISO134 3485 85 cer certi tifi fica cati tion on US$9 US$9 mill millio ions ns targ target et achi achiev eved ed US$1 US$12 2 mil milli lion onss tar targe gett achi achieve eved d

 PRODUCT & SERVICES  Manufacturers,

Suppliers

&

Exporters

of

-

Heart Lung Lung Pack, Pack, Cardio Cardiopleg plegia ia Delive Delivery ry System System,, Cardiac Cardiac Sur Surgery gery// Perfusio Perfusion n Systems Systems : Heart Arterial Arterial Filter (Adult/Pead/I (Adult/Pead/Infant) nfant),, Tubing Tubing Connectors Connectors Straight Straight & Y, Y, Purge Line, Gas Line Filt Filter ers, s, Isol Isolat ator or,, Thoracic/Drainage

Cann Cannul ulaa-Ar Arte teri rial al Catheter,

&

Venou enous, s, Quic Quick k

Tubing

Rolls

Prim Primee

Kit, Kit, Tubin ubing g

(Sterile/Non

Orga Organi nise serr,

Sterile).

Interventional Cardiology & Radiology : Manifolds, Control Syringe Hemostatic, Map Kits,

Guide Wires, High Pressure Line, Contrast Media Set, PTCA Kit, Angiography Kits, Inflation Device,

Introducer

Kit,

Introducer

Needle.

Anaesthesia & Critical Care : Disposable Transducer Kits, Pressure Monitoring Kits For-,

-Resuable Transducers, Transducer Domes, Flush Device, Pressure Monitoring Lines, Pressure Mon. Kit w/t Disp. Transducer, Transducer, Extension Lines With 3 Way Way Stopcock, Flow Regulator, Measure

Volume Set, Catheter Securement Devices-Statlock, Central Venous Catheters, Pulmonary Artery Catheter,

Thermodialution

Catheter.

Expandable le Circui Circuits, ts, Ventila entilator tor Circuit Circuits, s, Anaest Anaesthes hesia ia Circui Circuits, ts, HME Filter Filters, s, Respiratory : Expandab Ventilator Tubings, Water Trap, End Cuff Connector, Straight Connector, Elbow Connector, Swivel

Connector,

Y

Connectors

(with/without

Port),

Breathing

Bags.

Operating Room & Use : ECG Electrodes, Cautery Tip Cleaner, Cautery Pad, Cautery Pencils,

Needle Surgical Linen : Surgical Gowns, Surgical Masks, Surgical Caps, Shoe Cover, Draw Sheets,

Angiography Hemo He modi dial alys ysis is

Sheet,

Cardiovacular

Acce Access ssor orie iess

:

Pack, Blood

Custom Tubing,

Procedure Dialysis

Packs. Catheters.

Arguss Medi Medica cal, l, Swit Switze zerl rlan and, d, Augus Augusti tine ne Medi Medical cal Inc. Inc.,, USA, USA, Distribu Distribution tion Produc Products ts : Argu MEMSCAP, MEMSCAP, Norway, Eurosets SRL, Italy, Duxbury Scientific, USA, Helena Laboratories, USA, Luxtec Corporation, USA, Medical CV Inc., USA, Minntech, USA, Medical Concepts, USA, Jostra Jostra AG, Germany Germany,, Scanla Scanlan n Intern Internati ational onal,, USA, USA, Vinitec initec Intern Internati ational onal,, USA, USA, Vitalit italitec ec International, France.

OPERATIONS •

Manufacturing unit covers a total of approx. 30,000sq. ft

•

With a certified class 10,000 clean room

•

In house ETO sterilizers

•

Fully integrated microbiology lab

•

ISO 9001/ ISO13485 certified facility

•

CE marked products

Chapter 3 Reasons Companies Use The Payback Method Based On Empirical Studies with my Personal Pe rsonal Views Views 3.0 Reasons Companies Use the Payback Method It was discovered that while the payback method is used extensively by many companies, it is apparently used primarily in conjunction with other appraisal method. In a survey carried out by Schall 1978 , it was found that of the 74% of respondent firms that use the PB method, only 2%

use PB as their sole technique. A survey by Gitman and Forrester 1977 shows that while only 8.9% of the firms use the PB method as the primary technique of capital budgeting, 44%use it as a secondary technique. It is therefore generally said that firms use the PB method because they are not familiar with the sophisticated methods ( NPV & IRR) of capital budgeting since Schall 1978 report that 64% of the firms that use sophisticated methods also use the PB method.

An alternative explanation for the use of PB method may be, that it is an outcome of a conflict   bet betwe ween en the the inte intere rest st of the the owne owners rs of the the comp compan anie iess and and thos thosee of the the manag manager erss of the the organization. For ex: the owners of the organization would be indifferent between the two investment projects with the same NPV even though one has a longer payback period. This is  because the owners can sell their stock in the capital market at any time and collect the present value of future cash flows. Putting into considering the position of the managers who may not expect to stay with the organization for the economic life of the project due to some reasons. In a situation where management compensation is expected to be linked to the periodic earning

generated by the project, then they would prefer the project with a shorter PB period. The hypothesis that the payback method is beneficial to managers but not to owners is discussed also  by Weingartner 1969, Brealey and Myers 1981, and Statman 1982.

3.1 Simplicity of The Payback Period The payback period as discussed earlier also is used in many companies as a measure of  attractiveness in capital investments. In spite of critics, it is commonly used for appraisal of  capital investments. The simplicity of the payback period is evidence in that this method is often used as a screening device in which the obvious cases of profitable or unprofitable investments are sorted out, leaving the potential profitable investments to be scrutinized by discounted cash flows (DCF) financial appraisal methods ( NPV & IRR). The payback period indicates how quickly the cost of investment will be recovered but does not measure its profitability. It is designed to answer the question how soon the original cash outlay will be recovered; and this reveals the simplicity of Payback method.

3.2 The PB period in Relation to Pecking-order Theory Theory The way the companies should finance their investment has been very challenging for the managers. In making this decision the managers consider the capital structure and how their  decisions will affect it. The issue of pecking-order theory has been discussed in several articles; this tells us that in financing an investment, the management will consider the available cash, follow followed ed by the debt and finall finally y equity equity.. In implem implementi enting ng a capital capital intens intensive ive invest investmen ment, t, managers will be left to make decision in the form of way to find the funds. The 3 options left for  manager managers, s, have already already been discusse discussed d above above and follow following ing the trends trends which which depend depend on  pecking-order theory. The influence of the payback method can be link with the pecking-order  theory, if we look at it in such a way that the organization will like to get on investment that will  bring back the cost of outlay. Since the managers are not interested in increasing the debt ratio or  diluting the proportion of the shareholder equity, they will have to use methods that create immediate immediate liquidity liquidity for the company. company. This has therefore contributed contributed to the increased use of the

 payback period in corporate, despite the fact that it is being criticized by many academicians. Investment that will generate immediate cash flow will be highly favoured in which payback  method is the only method that will detect kind of investment options.

3.3 The PB period as Method for Risk Assessment in Capital Budgeting This is an excellent measure of risk. The payback period is the amount of time required for cash flows from the implemented solution to equal the original project cost. The payback period is a simple metric that determines when a project breaks even. Some companies use the discounted  payback method to determine the amount of time required to recover the project cost and earned the required rate of return. The PB period represents the risk time of the investment. If the solution fails to deliver the planned cash inflows, the capital expenditure will not accomplish its financial goals. In general shorter payback periods are more desirable than longer ones. The PB  period is an approximated economic analysis and all economic consequences after the PB period are completely excluded. The managers believe that the cash realized today is more realistic than the cash to be realized in future, this is the idea that the payback method supports which also shows how early an investment will recoup its initial outlay. Many managers are risk averse, so they are more interested in those projects which will generate cash flow quickly, because they are employees of the organization and they might get fired or change the company. This reason motivates the consideration of the risk of their employment, and favors the often use of the  payback method in capital investment decision.

3.4 The PB period in Relation to the Size of Company The researchers have been pointing to the fact that companies are bias to the use of investment appraisal in relation to their size. The classification of the size of the companies has been based on the turnover, asset base, profit and others. Some of the researchers concluded that companies size affect the type of the investment method used are John John R.Graham R.Graham 2000. and Gert Sandahl 2003, in which the data for the survey in which they base their conclusion is presented

in fourth chapter. Both the researchers conclude that small companies are bias in using the

 payback  payback method. The major reason supporting supporting this idea can be that the PB period is simple and effective communication. Small companies also are interested in immediate cash flow b ecause

they often lack the requirements to be able to source for fund. It cannot be neglected that the complex complexiti ities es of the other other invest investmen mentt apprai appraisal sal methods methods always always scare scare the small small company company managers. Basically if the small companies were involved in regular capital projects they might develop familiarity with complex methods.

3.5 Management Compensation & the Role of PB period The managers and shareholder goals has been influencing sometime the goal function that managers pursue. The shareholders are more interested in the growth and the profitability of the company, while the managers are more interested in what will bring them incentive in form of   bonus. The use of PB method can be traced to management-shareholder conflict. The managers are interested in the project that will quickly bring cash flow, because they are risk averse and might not stay long in the company. This is the reason they use payback method, because among the project investment appraisal method it is the cash flow that measure it. The work of Statman and Sepe 1984 , concluded that managers will always want to use payback   period method management interest which is linked to get compensation and incentive. Also Shimin Chen and Ronald L. Clark 1994 , carry out an investigation to establish a relation  between the firms that use the payback method in respect of compensation. The result of their  research shows, the firm that follow management goal objective often use the payback method in evaluating their investment.

Chapter 4 THE ANALYSIS OF COMPANIES THAT HAT USE THE PAYBACK METHOD FOR  APPRAISAL OF CAPITAL BUDGETING DECISION Research has been conducted on foreign countries companies to see the most used capital  budgeting methods used by managers. So for the purpose of this research, we will limit ourselves to the published papers in United Kingdom & Sweden, which relate to the survey conducted on companies in these two countries. The report of the survey of foreign countries is as follow:

Year of 

Researcher’s

Survey

&

Date

Response

of  

Response

Sample

Rate(%)

Frame

&

1973

Report Carsberg &

103

Industry 325, Times

1986

Hope(1976) Pike and

100

140

1989

Sharp(1989) Sangster(1993)

94

491, Scottish

companies 68

303,

Small

S. 1991

Drury et al(1993)

303

Companies 1269 , Management Accountants

Table 4.1: Report of Survey Conducted Conduc ted on Companies in U.K.

The research done by Carsberg & Hope shows that 59.2% of the respondent used traditional  payback method, while 39.8% used the discounted payback period. The survey also shows that the companies that use only one single method, the payback period was the most important method used. The survey of  Pike and Sharp also shows that the popularity of the payback   period in capital budgeting decision is increasing despite it’s critics objections. It was evidence that 92% of the firms still used the Payback method. Drury et al showed showed that PB was the most used capital budgeting technique. This analysis also reveals that the use of payback method in United Kingdom is important in capital budgeting decisions. Though many new techniques has  been introduced, but the practicing managers still still find it comfortable to use Payback method. Gert Sandhal and Stefan Sjogren conducted a research on the use of various capital budgeting techniques and the extracts are as follows: Capital Budgeting Techniques

%

using

the

various

budgeting

techniques(%)

Payback 78.1 N PV 52.3 Expenses Calculation 30.5 IRR 22.7 Accounting Rate of Return 21.1 Annuity 10.2 All DCF 64.8 Others 6.3 Table 4.2: Extract from the data on the use of capital budgeting budg eting method in Sweden

The conclusion drawn from the analysis is that many companies use the payback method. So we can say that shareholder maximization policy was not pursued by the company’s management in Sweden. The major reason for the increase in the use of payback period was focused on the liquidity rather than profitability, profitability, and we can say that companies are risk averse.

American Companies

A research was conducted by some of American companies on the development of payback  method and the companies that used this method. The analysis of  Fremgen(1973) shows that 67% of all respondents used the payback method. The analysis done by Petty et al (1975) also shows that the payback method was ranked first by 12% of the respondents and second by 44%. So the conclusion of the research is that the payback method is often o ften used than any other method. Hendricks (1988) shows in his analysis that 29% used the payback method as their primary

evaluati evaluation on techni technique que when when conside considerin ring g factory factory automa automatio tion n project projects, s, while while 48% use it as secondary technique, but he conclude that the payback method should be used as secondary evaluation measure. Basically, all the survey conducted shows that the payback method was commonly used in the American companies either as primary method or secondary method. It also shows that the trend of the use of payback period is growing. One more research survey was conducted by John R. Harvey. The following data was extracted from the survey of the questionnaire that asks – ‘How does your firm use the following technique when deciding investment?’

Capital Budgeting Techniques

The percentage of how often the method is been used(%)

Internal rate of return 75.61 Net present value 74.93 Payback period 56.74 Sensivity analysis 51.54 Discounted payback period 29.45 Accounting rate of return 20.29 Adjusted present value 10.78 Profitability Index 11.87 Hurdle rate 56.94 Table 4.3: Data extracted from the survey conducted by John R. Harvey Harve y

The survey shows that majority of the firms used the internal rate of return, while a noticeable  percentage of the firms used the payback method. But if the two payback period is combined (Traditional payback and Discounted payback), it will indicate that the number of the firms that

used the payback method is of the highest in the survey. So we can conclude that the trend of the  popularity of the payback method is still high in American firms, either as primary or secondary tool.

I had asked from the competitors competitors of BL Lifesciences a question through mail that – ‘Which are the primary capital budgeting methods used in evaluating e valuating the investments by your company?’

Which capital budgeting method is used most often by

Percentage(%)

your company? Internal rate of return Net present value Profitability index Accounting payback  Present value payback  Adjusted internal rate of return Other methods TOTAL Table 4.4: Report of question asked from the competitors

But the companies are not ready to provide the data. John Graham (2000) shows in his survey on American firms how the capital budgeting decision is influenced by the size of the company. The ranking was done by respondents who were asked to score how frequently they used the different capital budgeting techniques on a scale of 0 to 4, (0 meaning ‘Never’ and 4 meaning meaning ‘Always’). ‘Always’). The data is not available, but the analysis analysis of the survey showed that small companies used the payback period more than the large companies. Also the discounted payback period follows the same trend. The reason large companies mostly use NPV and IRR is because they always require more time to make investment than small

companies and they use complex method through regular use of the method on different capital investments at different times, while small companies mostly depend on the payback method  because of its simplicity and risk measurement incorporated in it.

Analysis of Data

The research survey was chosen from two different countries – Sweden and United Kingdom. The data used involve the survey on the use of the payback method for different years, which shows that the PB method was being used with the highest rate as 92% and lowest as 59%. The lowe lowest st was was in the the surv survey ey condu conducte cted d in 197 1976. 6. Ev Evid idenc encee from from the the repo report rtss has has show shown n that that manufacturing companies often used the payback period, compared to other sector. The issue of  the relevance of the use of the payback method is motivated by the importance of the payback  method which includes the size of the business, the goal function and basis of using simple appraisal method. While the simplicity and the size of the company can be traced to the use of  the payback method by financial managers, which is due to the fact that they always want to avoid the use of complex method and also lack of sufficient funds.

I have been able to find out why payback method is often used in different countries based on empirical analysis carried out by researchers in that field and also why some particular countries  prefer payback method, which primarily based on such kind of industries that run the economy, ex: manufacturing industry. It is evident that the manufacturing industries often use the payback    period in analyzing their investment opportunities. The major reason is that manufacturing company often embark on capital projects and availability of liquidity is highly important in executing such projects, which have made them to always embark on effective working capital management. management. Another Another thing is that any manufacturing manufacturing company will not want to hold down the capital for long, because a cash gained today is certain than expected cash in future. Considering the secondary data, the attitude of the finance manager can be traced and how they intend to raise funds to finance their business. They use the payback method because of the availability of the internal funding. Also the simplicity of the payback period has motivated the use of the method.

Managers normally want to use a very simple formula to make their investment decision. Although developed countries are now more interested in using complex formulas like real option approach, NPV, IRR but the conclusion is that the simplicity of the payback method it to  be easily understood and has motivated the general use of the payback method.

The risk taking of the finance manager also indicate why the payback method is often used. The consci conscious ousnes nesss of manager managerss has made made payback payback a better better tool tool for invest investmen mentt apprai appraisal sal.. The manager generally wants to embark on those projects which will generate immediate cash flows. The major reason for this kind of attitude is that most businesses are run on loan and overdraft. The analysis shows that size of the company also motivated the use of payback method. Small companies survive mainly on investment that can generate immediate liquidity and the major  invest investmen mentt method method that that suppor supportt this this idea idea is the payback payback method method and to encoura encourage ge small small compani companies es banks banks are provid providing ing loans at reduce reduce intere interest st rate. rate. Manager Managerss are biased biased on the investments that generate immediate cash flows, because their bonuses are attached with it. This can be viewed that despite the awareness of other appraisal methods managers are interested in using payback method. In conclusion, putting all these analyses together, it is revealed that companies prefer the use of  the payback method.

Limitation of Data Analysis Analysis Although the data used in the research is extracted from published articles, the limitations of the analysis may be based on some changes chang es that might have occurred over o ver time.

Chapter 5

CONCLUSION

The importance of using investment appraisal method in capital budgeting has gained a wide acceptance in the industries. Different method has been employed, but the significant of using the payback method has been increasing every time despite its critics. The reason why many of  the managers still prefer using the payback method can be traced to different reasons like the simpli simplicit city y of the method. method. Managers Managers try to avoid avoid other other apprai appraisal sal methods methods because because of the complexity that is built in it. The manager’s incentives packages has been another reason why managers has retain this old method in practice, managers will always want to use appraisal method that will support their incentive plan which it always link to accounting earning. The managers pursuing of the management objective against the shareholders, has always been traced to employment contract which tied incentive to earning which is also link to the cash flow. The  payback method is the most effective method to decide this type of investment that will generate quick cash flow. flow.

Actually Actually,, the idea that the payback payback method does not measure measure profitabili profitability ty is far from the truth, the method does measure profitability profitability.. The payback method method is the reciprocal reciprocal of internal internal rate of  return, and IRR is used to measure the profitability of an investment through the decision of  higher IRR to cost of capital of the company for single project, or the highest in of the IRR in case of many projects. projects. So we can conclude that the payback method indirectly indirectly can measure measure the  profitability of investment so also its profitability.

The important of risk and the uncertainty that the payback period method has included has really  been of such a great advantage advantage for the method. Managers Managers will always want to guide against the uncertainty in the future cash flow, which may be due to new entry into the industry, customer  dissatisfaction, government legislature and many unprepared reasons for that. The lengthy the

time to generate the cash flow the risk is the investment. So the managers prefer to use method like the payback method to select a project that will have shorter payback period in order to minimize the risk.

The use of the payback method will always have its relevance relevance in the corporate corporate organizati organization on for  evaluating of capital project because of its major advantages that have been shown in this   pro proje ject ct.. All All manag manager erss shoul should d try try to invol involve ve the the use use of anoth another er inves investm tmen entt meth method od as complementary method in order to make a sound investment decision out of the available options.

Reference

•

Don Dayana Dayanand nda a 2002, 2002, John John Her Herbon bon,, Steve Steve Harris Harrison on – “Capit “Capital al Bud Budget geting ing:: Financial Appraisal of Investment Projects” Link – http:/www.questia.com/read

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Drur Drury y, C. Br Brau aund nd,, Osbo Osborn rnee P. and and Tayle ayle 1993 1993,, - “A Su Surv rvey ey of Mana Manage geri rial al Accounting Practices in UK Manufacturing companies.” Link – http:/www.emeraldinsight.com/insight/viewcontent

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James Fremgen 1973, - “Capital Budgeting Models: Theory vs Practice, random sample of 250 business firms in 1973” Link – http:/www.entrepreneur.com/tradejournals/article/116186585

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Long Longmo morre, D.19 D.1989 89,, - “IRR “IRR,, NPV NPV and and Payb Paybac ack k Perio eriod d & Th Thei eirr Rela Relati tive ve Performance” Link – http:/www.entrepreneur.com/tradejournal/article/15151802_7

•

Mere Statman & James F. Sepe, 1984, - “Managerial Incentive Plans and The Use of  Payback Method” Link – http:/www.interscience.wiley.com/journal(119532171)

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Petty Petty J.W. J.W. Scott Scott Jr. Jr. D.F. D.F. and Bird M.M., - “The Capital Capital Expendit Expenditur uree Decision Decision Making Process of Large Corporations” Link – http:/www.springerlink.com/contentvt7g648170kwh78fulltext.pdf 

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Pike, R.H. (1985), - “Disillusion With DCF Promotes Promotes IRR” Link  http://books.google.co.in/books?id=SzJZ5TjFcb8C&pg=PA51&lpg=PA51&dq=Pike, R.H.(1985),+Disenchantment+with+DCF+promotes+IRR.&source=bl&ots=rdKeiX yfXX&sig=I1ucI1mWNO9hWiJMS1D22HpaXFY&hl=en&ei=HzqESufiNZiQkQW 5mNyWBw&sa=X&oi=book_result&ct=result&resnum=1#v=onepage&q=&f=false

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Ross 1972, - “Sophisticated Methods of Capital Budgeting An Economics of Internal Organization Approach” Link – http:/emeraldinsight.com/10.1108/eb013599